Bogus Gold

Big news today about the latest in a seemingly endless series of bailouts for American International Group (AIG). This follows quickly upon the news that this same failing corporation posted the largest single quarter loss of all time - $61.7 billion dollars.

There's a lot of grumbling out there about "fat cats" and "corporate welfare" and "socialism" and all the rest of the usual finger pointing that goes on at such times. But I find Joe Nocera's New York Times article about AIG far more illuminating on what's really happening. Oh there is plenty of blame to go around. But it's not remotely as simple as you might think:

If we let A.I.G. fail, said Seamus P. McMahon, a banking expert at Booz & Company, other institutions, including pension funds and American and European banks “will face their own capital and liquidity crisis, and we could have a domino effect.” A bailout of A.I.G. is really a bailout of its trading partners — which essentially constitutes the entire Western banking system.

I don’t doubt this bit of conventional wisdom; after the calamity that followed the fall of Lehman Brothers, which was far less enmeshed in the global financial system than A.I.G., who would dare allow the world’s biggest insurer to fail? Who would want to take that risk? But that doesn’t mean we should feel resigned about what is happening at A.I.G. In fact, we should be furious. More than even Citi or Merrill, A.I.G. is ground zero for the practices that led the financial system to ruin.

My emphasis above. I point it out because it's important to understand the panic that swept through Washington late last year, which drove the outgoing Bush administration to get us started down this endless bailout path. Remember hearing how we were facing the possibility of a collapse of our banking system without a bailout? It wasn't a bluff and it wasn't a mischaracterization of the matter. The problem is, we've simply put a band-aid on it for now. The fundamental wound remains. And what kind of wound is it exactly?

Well it starts here...

As a huge multinational insurance company, with a storied history and a reputation for being extremely well run, A.I.G. had one of the most precious prizes in all of business: an AAA rating, held by no more than a dozen or so companies in the United States. That meant ratings agencies believed its chance of defaulting was just about zero. It also meant it could borrow more cheaply than other companies with lower ratings.

Fundamental to unweaving the tangled mess following its collapse, one must remember this. It was based on the notion that AIG - owing to its AAA rating - simply could not default. It wasn't even necessary to calculate the risk once AIG stamped it's AAA rating on something. And yes, it really was that simple...

Unlike many of the Wall Street investment banks, A.I.G. didn’t specialize in pooling subprime mortgages into securities. Instead, it sold credit-default swaps.

These exotic instruments acted as a form of insurance for the securities. In effect, A.I.G. was saying if, by some remote chance (ha!) those mortgage-backed securities suffered losses, the company would be on the hook for the losses. And because A.I.G. had that AAA rating, when it sprinkled its holy water over those mortgage-backed securities, suddenly they had AAA ratings too.

That's enough swiping from Nocera. I encourage you to go read his article yourself for a more complete view of how these two fundamentals - AIG's AAA rating, and credit-default swaps - wove their way through the banking system of the entire Western world. The important takeaway was that it DID weave its way through the banking system of the entire Western world, which means the failure of an AIG will pull down who knows how many other financial institutions. Even now, after billions upon billions to prop them up, there's still more needed to prevent that very outcome.

That's the key thing that distinguishes bailing out AIG from bailing out General Motors and Chrysler. We're not bailing out because we're worried about all the layoffs, or the loss of a key industry to overseas competition. We're bailing them out because if they go down they could take our entire banking system with them. Not just your 401K, but your ability to get a loan - any loan. For anything. For the forseeable future. Multiply "you" by the factor of "and everyone else including businesses," and you begin to see the scope of the problem.

However, hindsight is easy. We can all sit around feeling like geniuses NOW, because we know how this all played out. But I didn't hear many people jumping up and down sounding alarm bells before it all collapsed. And there is a good reason for it which even excellent analyses like Nocera's tend to obscure. The reason is the guys who were doing it all were extremely smart, making money hand over fist for everyone, and unlike some kind of con-job they honestly believed they were right.

It wasn't malice, but rather extreme confidence - hubris, if you prefer - which made a venerable and respected financial institution like AIG destroy its reputation, its finances, and nearly the whole Western banking system. However, once again, let's not grow so fond of finger pointing that we forget that none of this was being done in secret. This was done openly. Indeed the market was clamoring for more of it.

For some perspective, I dug up a paper from the recent past. Credit Risk and Regulatory Capital (pdf), from the International Swaps and Derivatives Association (ISDA) in 1998. Feel free to dig in yourself, as it's very illuminating in conjunction with the Nocera piece. But here's the eye opening gist of it lifted from the executive summary:

ISDA believes there is an urgent need to
reform the credit risk capital regime

ISDA recommends an “Evolutionary Models-
Based Approach” as a framework for reform,
allowing use of portfolio credit risk models or
– as an interim step – simple credit risk
models, as an alternative to the current
standardised rules

ISDA recommends that the current
regulatory capital treatment of collateral be
revised, as this is inconsistent and out of step
with current market practice

ISDA calls on the financial industry to
encourage the use of improved credit risk
management techniques

In a nutshell, they were lobbying to:

A. Immediately reform the rules for credit risk capital.
B. Rely on modeling as a superior barometer to standardised rules for protecting investments.
C. Dismantle the need to keep their investments backed by sufficient pools of capital, as an unneeded legacy of an outdated system.
D. Get the entire financial industry using this stuff quickly in the name of improving their credit risk management.

If we take one lesson away from this whole debacle let it be this one. This fiasco spread through the financial sector in the name of making an improvement to credit risk. Why did they think it was an improvement? Because they had models, which were supposed to keep up with real risk in a changing market far more nimbly than some "one size fits all" regulation.

When you read through the Nocero article on AIG you run into this very element at every critical juncture. People knew their investments were not at risk, because they were insured by AIG. AIG knew they were not at risk, because they were backed by mortgage based securities. AIG knew mortgage based securities couldn't fail, because their models told them so.

Unfortunately, as we now know, reliance on models - especially when they give you the answers you're looking for - introduces its own kind of risk. And sadly no one thought to "model" that.